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What if they gave a $700 billion bailout and nobody came?
It's a real possibility. And it would doom the plan to rescue Wall Street with $700 billion in taxpayer money.
All the hearings and late-night meetings have focused on how to improve the plan proposed by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke. The modifications being considered would indeed do a better job of protecting taxpayers, ensuring someone was watching while the Treasury forked out the moola and giving taxpayers some stake in the companies they'd be bailing out. (See my column "Let's not rush to blow $700 billion.")
The proposals being discussed now, like the original plan, pretty much assume it'd work for the government to buy the busted assets that now choke the financial markets -- and that all that's left to question are details like how much the government would pay and who would manage the portfolio.
Throwing $700 billion at Wall Street, everyone seems to believe, would restore confidence in the financial markets, repair the balance sheets of U.S. banks and other financial institutions, and get the great national borrowing-and-lending machine back up and running so the economy would start creating jobs again.
But the odds are no better than 50-50 that even an improved plan could accomplish that near-term fix -- to say nothing of reforming the financial markets to avoid a recurrence of this crisis or a similar one. I expect Wall Street to cheer and global stock markets to soar if and when a deal is announced. Stocks could even rally through the end of the year.
It would take three months or so, however, before we knew whether the plan was truly restoring something like business as usual in the financial system. If the plan failed, we could be looking at a resumption of the crisis in January or February.
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Stopping the chain reaction
Let me tell you first why the success of the plan would be no sure thing. Then I'll tell you why investors need to keep their heads if congressional approval creates a year-end rally.The plan assumes that CEOs at banks and other financial institutions would love to remove tens and hundreds of billions of mortgage-backed securities, credit-default swaps, collateralized debt obligations and related financial paper from their balance sheets. The market for many of these kinds of assets has locked down tight, so they can't be sold at any price because no one knows what they are actually worth. And every time a competitor like a Lehman Bros. (LEHMQ, news, msgs), an American International Group (AIG, news, msgs) or a Citigroup (C, news, msgs) is forced to sell an asset, it sets off a chain reaction of losses as everybody else has to mark their portfolios down to reflect the new, fire-sale price.
Whenever an asset gets marked down and the value of a company's portfolio falls, a CEO faces the prospect of having to raise more capital, either because the company's capital now falls below regulatory minimums or because the financial companies it does business with demand more collateral. Raising capital in today's market is impossible for some financial companies and incredibly expensive for even the best of them. The deal Goldman Sachs (GS, news, msgs) struck with Warren Buffett for $5 billion in capital cost a 10% rate of interest and an option that lets Buffett buy more shares at a discount of more than 10% off the current market price for Goldman shares.
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I agree with Paulson and Bernanke that CEOs would love to get rid of these toxic assets and would love to step off the treadmill of constant asset downgrades and capital calls. But I'm not sure the plan would lead most CEOs to sell the garbage on their books to the government. There are pretty big incentives not to sell, in fact. Of course, if companies don't sell, the financial markets stay frozen, the economy continues to be starved of capital, and growth continues to fall.
To understand why CEOs might not come rushing to the Treasury to unload their worst assets, you have to understand a bit -- just a bit, I promise -- about bank accounting. Financial companies are supposed to mark the prices of the stuff they hold in their portfolios to something called fair value, according to the accounting rules.
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